When I want to get my fill of nonpartisan tax discussion, there’s nothing that gets the job done quite like the Tax Policy Center. It’s always filled with rich, creamy tax goodness, and today is no exception.

As a reminder, Romney would slash the current tax rates by 20% — leaving us with a maximum individual income tax rate of 28% — while also eliminating the tax on interest, dividends, and capital gains for those earning less than $200,000. Romney has promised to pay for the cuts by broadening the tax base by eliminating popular deductions, but he’s never clarified what deductions would have to go. Nor have we ever seen a study formally quantifying 1) the cost of the proposed rate cuts in terms of lost revenue, and 2) the offsetting revenue that can be gained by putting an end to some of the larger deductions; namely, the deductions for mortgage interest, state and local taxes, and charitable contributions.

As we wrote back in May, the concern is not whether broadening the base enough to offset the revenue lost from rate cuts is mathematically possible, but rather whether its realistically feasible given all the factors working against eliminating deductions: special interest groups, the need to curry votes, matters of public policy, etc…

Well, the brilliant minds at the Tax Policy Center have once again done the dirty work for us. They took a good, hard look at the theory of broadening the base enough to pay for a 20% across-the-board tax cut, though they did so without formally examining Romney’s specific proposal.

To start, the Center echoes our concerns about the reality of cutting popular deductions, while adding some additional roadblocks to the equation:

1. Lower rates reduce the value of most tax preferences. Nearly all tax expenditures are in the form of deductions, exclusions, exemptions, deferrals, or preferential rates, all of which are valuable only to the extent they allow taxpayers to avoid regular statutory tax rates. If tax rates are cut, the value of these tax preferences goes down as well. Thus, cutting tax rates reduces the amount of offsetting revenue that cutting tax preferences can raise.

[Ed note: this is the tax equivalent of the dog chasing its tail. As the rates get cut, so does the revenue raised from cutting $1 of expenses. To illustrate, if tax rates are currently 35%, a $100 mortgage deduction would yield $35 of lost revenue. However, if the tax rates are cut to 28% and the mortgage deduction is eliminated, while you are losing 7% tax revenue on the income side, you are not gaining up $35 of revenue by getting rid of the mortgage interest deduction. You’re only gaining $28, the value of the deduction under the new tax rate.]

2. Some tax preferences may be hard to curtail for political or administrative reasons. For example, cutting back widely used and popular preferences such as the deductions for mortgage interest and charitable contributions may be politically difficult. If such preferences can’t be curtailed as part of a realistic tax reform, it becomes harder to find the revenue needed to pay for lower tax rates.

[Ed note: this has always been Issue #1 I have with the Romney proposal. Is he really going to win election, immediately cut the rates, and then tell his Republican constituents to bid farewell to their beloved mortgage interest deduction? Doubtful.]

3. Cutting back on tax preferences may alter the distribution of the tax burden in ways that are deemed unacceptable. Finding a combination of lower rates and cutbacks in tax preferences with acceptable distributional effects can prove quite difficult.

[Ed note: Stated differently, cutting tax rates and broadening the tax base usually leads to a disproportionate result: the taxes of the wealthiest taxpayers are usually reduced to a much larger degree than lower and middle class taxpayers.]

4. A tax reform that includes wholesale, immediate repeal of a significant portion of tax preferences would significantly disrupt existing economic arrangements in ways that might be deemed unfair. Instead, some preferences might be only partially curtailed, and some cutbacks might phase in, possibly over an extended period of time. In addition, taxpayers would likely change their behavior to lessen the impact of these cutbacks. All of these “real world” effects would likely reduce, perhaps substantially, the revenue gains from cutting tax preferences.

[Ed note: For example, if the charitable contribution deduction were to disappear on January 1, 2013, human nature would dictate that people would give less to charity in 2013, reducing the value of the eliminated deduction.]

The Center then examines whether the base can be broadened enough to offset the revenue caused by the rate cuts by comparing a proposed tax regime with a top rate of 28% with LTCG and dividends continuing to be taxed at 15%, titled “Current Policy with Reduced Rates,” with two different baselines:

1. One where the current law continues (maximum rate 35%/LTCG rate of 15%), titled “Current Policy,” and alternatively

The Center determines that under each alternative, the individual income tax revenue expected to be generated during 2015 is as follows:

Current Policy with Reduced Rates: $1.0 trillion

Current Policy: $1.3 trillion

Current Law: $1.7 trillion

[Ed note: This would seem to indicate that Romney’s plan would cause a reduction of $0.7 trillion in revenue as compared to the revenue generated should the Bush tax cuts expire, and a $0.3 trillion reduction in revenue over current policy. However, the Tax Policy Center’s analysis does not incorporate the fact that Romney would eliminate the tax on interest, dividends, and capital gains for those earning less than $200,000, a factor that would likely widen this disparity greatly.]

Making Up the Lost Revenue When Compared to Current Policy

The Center next determines that in order to offset the $0.3 trillion in revenue from a Current Policy baseline by cutting the rates, 72% of the following deductions would have to go:

Mortgage interest,

Charitable contributions,

State and local taxes,

Medical expenses,

All above-the-line deductions,

Exclusion for employer provided health insurance,

Education, energy, and other credits expect those related to children and low-income families,

The exclusion for income earned abroad.

Of course, 72% of each deduction wouldn’t have to go, but some combination of these expenses must be eliminated so that 72% of the benefit under Current Policy is eliminated. Either way, that’s a damn lengthy list with some high profile deductions on the chopping block. Take even one of the deductions in the group off the table, of course, and the percentage of the remaining deductions that have to be eliminated skyrockets.

Predictably, cutting the rates by 20% compared to current policy and eliminating 72% of these deductions would actually serve to decrease the net tax burden of the wealthiest 20%, while increasing the tax burden of the remaining 80%. Because this country has long prided itself on having a progressive tax system, this would be a tough pill for 80% of Americans to swallow.

Making Up the Lost Revenue When Compared to Current Law

Things get much more daunting, however, when the Center takes on the task of making up the $0.7 trillion in lost 2015 revenue caused by reducing the rates when compared with Current Law. To gain that much back in base broadening, 75% of the following preferences would have to be eliminated in addition to 100% of those listed previously:

The special 20% capital gains rate that would apply under current law

The deduction or exclusion of contributions to retirement accounts

The exclusion of investment income accrued in retirement accounts

The exclusion of interest on tax-exempt bonds.

Summary

I’m no genius, but it would appear to me that reducing the current tax rates by 20% while maintaining revenue neutrality is next to impossible. In a country where the preferential tax treatment afforded private equity fund managers continues to exist for no justifiable reason other than the significant support it garners from deep pocketed lobbyists, it is absolutely inconceivable to me that any president could be expected to push through so many high-profile tax preferences when each presents its own endless string of powerful supporters. And even if he could, unless the resulting tax distribution maintains its current progressivity, it’s going to be a very tough sell in this era of budding “class warfare.”

Of course, those guys at the Tax Policy Center are geniuses, so why not get their take on what they found:

With sufficient base broadening, tax rates under both Current Policy and Current Policy with Reduced Rates could raise the same amount of individual income tax revenue as Current Law. However, meeting that goal under Current Policy would require a sharp curtailment of mortgage interest, charitable contributions, and employer-provided health insurance. Hitting that revenue target under Current Policy with Reduced Rates would be even harder. It would require curtailment of these same popular tax expenditures as well as substantial reductions of additional tax expenditures, such as the special rates for capital gains and dividends, the exclusions for retirement contributions and earnings, and possibly such items as the earned income tax credit (EITC), the Child Tax Credit, and the exclusion of some or all Social Security benefits for low- to moderate-income beneficiaries. From a political perspective, matching Current Law revenue would be difficult, if not impossible.

Look, I get it. Having to fork over most of your hard-earned cash to your ex-wife every month must totally suck. Particularly when everyone in town knows she’s been using the money to shower her new 23-year old boy-toy with Ed Hardy gear. If it were me, I’d want to blow up her car deduct the payments on my tax return too, if only to ease my pain with the resulting 35% tax benefit.

But there’s the tax law to be dealt with, and despite taxpayers’ consistent inability to comprehend the statute governing alimony payments, it’s not overly complicated. Alimony payments are deductible; child support payments aren’t. In order for a payment to qualify as deductible alimony under I.R.C. § 215, all four of the following conditions must be met:

1. The payment is received by (or on behalf of) a spouse under a divorce or separation instrument,

2. The divorce or separation instrument does not designate such payment as a payment which is not includible in gross income and not allowable as a deduction under section 215,

3. In the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and

4. There is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

Now, while I can see where tests 1, 3, and 4, could potentially create some controversy, #2 is about as straightforward as it comes. The agreement either says the payment is not deductible/not includible or it doesn’t. No way that would ever be litigated, right?

In 2008, Kouskoutis and his wife separated. A temporary order was drafted up in the divorce case containing the following requirement:

8. Once [petitioner’s former spouse] moves from the marital residence, [petitioner] shall pay [petitioner’s former spouse] unallocated family support in the amount of $3725.00 per month . [Petitioner’s former spouse] shall not be required to report such payments as income on her tax return. [Emphasis added.].

Undeterred by such plain language, Kouskoutis deducted payments of $44,700 he made to his ex-wife in 2008 as alimony. The IRS denied the deduction, alleging they failed to meet the definition of deductible alimony because the payments were designated as non-includible income to his wife.

The Tax Court, by virtue of employing individuals who can actually read, sided with the IRS.

In the instant case, however, paragraph 8 of the Temporary Orders contains a clear, explicit, and express direction that the disputed payments are not to be includible in the income of petitioner’s former spouse. Although the language does not precisely mimic the language of section 71(b)(1)(B), we hold that the substance of a nonalimony designation is reflected in the Temporary Orders. Consequently, the disputed payments do not meet all four of the conjunctive requirements provided by section 71(b)(1) and thus do not constitute alimony or separate maintenance payments deductible under section 215(a).

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

Email Subscription

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Authors

Our tax specialists have a comprehensive understanding of international, federal, state and local tax regulations. We work with you to ensure tax reporting obligations are met in an accurate and timely manner, and to minimize or defer the payment of taxes, thereby adding value to your company. Through the use of technology, we stay up-to-the-minute on tax law changes, and know how they affect your business. Through our affiliation with HLB International, we can also assist you in developing cost-effective tax strategies anywhere in the world.